Hedge funds have been getting crushed, and it is hurting everyone else in the market

Hedge funds are having a tough time, making life much harder for
everyone else in the market.

The industry's poor performance lately has investors pulling
money out of the funds.

That has led to a dropoff in bond-market liquidity, as funds that
might have snapped up bonds as their prices fell instead steer
clear, said Mark Heppenstall, chief investment officer of Penn
Mutual Asset Management.

"Hedge funds were a backstop for the markets and helped
provide that liquidity," said Heppenstall, who oversees
over $20 billion in assets managing the investment arm of Penn
Mutual Insurance. "So when they started to underperform for a
while and started to shift into risk off, it eliminated
that."

That shift has made life harder for everyone.

"Liquidity is the main source of the extreme downward and upward
moves in the market right now," he said in an interview with
Business Insider.

The original problem

Liquidity, in the most basic sense, is the idea that sellers can
find buyers easily and vice versa. So when liquidity dries up,
the sellers have to drop their asking price to find someone
willing to take on the asset.

Typically, before the 2008 crisis, there were two buyers of last
resort: banks and hedge funds. Because of regulatory
requirements, big banks no longer have that capacity.

"The ability of [Wall] Street to cushion the flows just
isn't there anymore," Heppenstall said. "They aren't in a place
where they can absorb any of the selling or volatility."

That puts the onus on hedge funds to be the backstop buyer in the
postrecession world. But funds
as a whole have begun to struggle. Hedge funds are down 3.8%
on average in 2016, driving up the rate of redemptions from
investors.

Penn Mutual Asset Management

According to data from eVestment, about $21.5 billion was
returned to investors from hedge funds in January, the most to
start the year since 2009. To prepare themselves from these
redemptions, and to try to improve performance, hedge funds have
been moving out of riskier assets.

"I just think hedge funds are clearing the decks of riskier
assets right now, and my feel is that they're pretty well through
the process," Heppenstall said.

This trend has also been exacerbated by the closing of large
funds. Heppenstall referred to
the closing of Third Avenue Management, and its
junk-bond-focused fund that collapsed in mid-December, as a
reason some other funds have moved to safer ground.

This nervousness over closings also makes sense. The
Federal Reserve Bank of New York
found in a recent studythat the risk of a "firesale"
of redemptions spreading among funds and affecting financial
markets was at its highest level in a decade.

"The fact that some large funds, such as Third Avenue, were
facing redemptions, that changed the appetite for all funds in
terms of risk," Heppenstall said.

All this adds up to a rougher environment for investors like
Heppenstall.

"While I'm expecting some near-term calmness over the next month
or two," he said, "this sort of volatility and liquidity risk is
not going away."